CHAPTE

R 2
Thinking Like An
Economist
PRINCIPLES OF

Economics
N. Gregory
Mankiw
Premium PowerPoint Slides
by Ron Cronovich
2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these
questions:
What are economists two roles? How do they differ?
What are models? How do economists use them?
What are the elements of the Circular-Flow Diagram?
What concepts does the diagram illustrate?
How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
What is the difference between microeconomics and
macroeconomics? Between positive and normative?
2
The Economist as Scientist
Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it
In the first, economists employ the
scientific method,
the dispassionate development and testing of
theories about how the world works.

THINKING LIKE AN ECONOMIST 3

Assumptions & Models
Assumptions simplify the complex world,
make it easier to understand.
Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic
issues.

THINKING LIKE AN ECONOMIST 4

 Our First Model:
The Circular-Flow Diagram
The Circular-Flow Diagram: a visual model of
the economy, shows how rupee flow through
markets among households and firms
Two types of actors:
households
firms
Two markets:
the market for goods and services
the market for factors of production

THINKING LIKE AN ECONOMIST 5

Factors of Production
Factors of production: the resources the
economy uses to produce goods & services,
including
labor
land
capital (buildings & machines used in
production)

THINKING LIKE AN ECONOMIST 6

FIGURE 1: The Circular-Flow Diagram

Households:
Households:
Own
Own thethe factors
factors of
of production,
production,
sell/rent
sell/rent them
them to
to firms
firms for
for income
income
Buy
Buy and
and consume
consume goods
goods & & services
services

Firms Households

Firms:
Firms:
Buy/hire
Buy/hire factors
factors of
of production,
production,

use
use them
them to to produce
produce goods
goods
and
and services
services
Sell
Sell goods
THINKING goods
LIKE && services
services
AN ECONOMIST 7
FIGURE 1: The Circular-Flow Diagram Two
Sectors
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
THINKING LIKE AN ECONOMIST 8
FIGURE 2: The Circular-Flow Diagram Four
Sectors

THINKING LIKE AN ECONOMIST 9

 Our Second Model:
The Production Possibilities
Frontier
The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology
Example:
Two goods: computers and wheat
One resource: labor (measured in hours)
Economy has 50,000 labor hours per month
available for production.
THINKING LIKE AN ECONOMIST 10
 PPF Example
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
PPF Example

Production
Point
on Com-
graph puters Wheat E

A 500 0 D
B 400 1,000
C
C 250 2,500
D 100 4,000 B
E 0 5,000 A

THINKING LIKE AN ECONOMIST 12

ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?

13
 ACTIVE LEARNING 1
Answers
Point F:
100 computers,
3000 tons wheat
Point F requires
40,000 hours
of labor. F
Possible but
not efficient:
could get more
of either good
w/o sacrificing
any of the other.
14
ACTIVE LEARNING 1
Answers
Point G:
300 computers,
3500 tons wheat

Point G requires G
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
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The PPF: What We Know So
Far
Points on the PPF (like A E)
possible
efficient: all resources are fully utilized
Points under the PPF (like F)
possible
not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
not possible

THINKING LIKE AN ECONOMIST 16

 The PPF and Opportunity
Cost
Recall: The opportunity cost of an item
is what must be given up to obtain that item.
Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

THINKING LIKE AN ECONOMIST 17

 The PPF and Opportunity Cost
The slope of a line
equals the
1000 rise over the run,
slope = = 10
100 the amount the line
rises when you
move to the right
by one unit.

Here, the
opportunity cost of
a computer is
10 tons of wheat.

THINKING LIKE AN ECONOMIST 18

ACTIVE LEARNING 2
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND

19
ACTIVE LEARNING 2
Answers
England, because its PPF is not as steep as Frances.
FRANCE ENGLAND

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Economic Growth and the PPF
With additional
resources or an Economic
Economic
improvement in growth
growth shifts
shifts
the
the PPF
PPF
technology,
outward.
outward.
the economy can
produce more
computers,
more wheat,
or any combination
in between.

THINKING LIKE AN ECONOMIST 21

The Shape of the PPF
The PPF could be a straight line, or bow-shaped
Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a
computer was always 10 tons of wheat.)
If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.

THINKING LIKE AN ECONOMIST 22

 Why the PPF Might Be Bow-
Shaped
As the economy

Beer
shifts resources
from beer to
mountain bikes:
PPF becomes
steeper
opp. cost of
mountain bikes
increases
Mountain
Bikes
THINKING LIKE AN ECONOMIST 23
 Why the PPF Might Be Bow-
Shaped
At point A, At
At A,
A, opp.
opp. cost
cost of
of

Beer
A mtn
mtn bikes
bikes is
is low.
low.
most workers are
producing beer,
even those that
are better suited
to building bikes.
So, do not have to
give up much beer to
get more bikes.

Mountain
Bikes
THINKING LIKE AN ECONOMIST 24
 Why the PPF Might Be Bow-
Shaped
At B, most workers

Beer
At
At B,
B, opp.
opp. cost
cost
are producing bikes.
of
of mtn
mtn bikes
bikes
The few left in beer
is
is high.
high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,

would cause a big Mountain

drop in beer output. Bikes
THINKING LIKE AN ECONOMIST 25
 Why the PPF Might Be Bow-
Shaped
So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs
(E.g., different types of land suited for
different uses).

THINKING LIKE AN ECONOMIST 26

The PPF: A Summary
The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.

The PPF illustrates the concepts of

tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.

A bow-shaped PPF illustrates the concept of

increasing opportunity cost.

THINKING LIKE AN ECONOMIST 27

Microeconomics and
Macroeconomics
Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
These two branches of economics are closely
intertwined, yet distinct they address different
questions.

THINKING LIKE AN ECONOMIST 28

The Economist as Policy
Advisor
As scientists, economists make
positive statements,
which attempt to describe the world as it is.
As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
Positive statements can be confirmed or refuted,
normative statements cannot.
Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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ACTIVE LEARNING 3
Identifying positive vs.
normative
Which of these statements are positive and which
are normative? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.

30
ACTIVE LEARNING 3
Answers
a. Prices rise when the government increases the
quantity of money.
Positive describes a relationship, could use
data to confirm or refute.
b. The government should print less money.
Normative this is a value judgment, cannot be
confirmed or refuted.

31
ACTIVE LEARNING 3
Answers
c. A tax cut is needed to stimulate the economy.
Normative another value judgment.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
Positive describes a relationship.
Note that a statement need not be true to be
positive.

32
Why Economists Disagree
Economists often give conflicting policy advice.
They sometimes disagree about the validity of
alternative positive theories about the world.
They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
Yet, there are many propositions about which
most economists agree.

THINKING LIKE AN ECONOMIST 33

Propositions about Which Most
Economists Agree (and % who
agree)
A ceiling on rents reduces the quantity and quality
of housing available. (93%)
Tariffs and import quotas usually reduce general
economic welfare. (93%)
The United States should not restrict employers
from outsourcing work to foreign countries. (90%)
The United States should eliminate agriculture
subsidies. (85%)

continued
THINKING LIKE AN ECONOMIST 34
Propositions about Which Most
Economists Agree (and % agreeing)
The gap between Social Security funds and
expenditures will become unsustainably large
within the next fifty years if current policies remain
unchanged. (85%)
A large federal budget deficit has an adverse effect
on the economy. (83%)
A minimum wage increases unemployment among
young and unskilled workers. (79%)
Effluent taxes and marketable pollution permits
represent a better approach to pollution control
than imposition of pollution ceilings. (78%)

THINKING LIKE AN ECONOMIST 35

FYI: Who Studies Economics?
Ronald Reagan, President of the United States
Barbara Boxer, U.S. Senator
Sandra Day-OConnor, Former Supreme Court Justice
Anthony Zinni, Former General, U.S. Marine Corps
Kofi Annan, Former Secretary General, United Nations
Meg Witman, Chief Executive Officer, eBay
Steve Ballmer, Chief Executive Officer, Microsoft
Arnold Schwarzenegger, Governor of California, Actor
Ben Stein, Political Speechwriter, Actor, Game Show Host
Mick Jagger, Singer for the Rolling Stones
John Elway, NFL Quarterback
Tiger Woods, Golfer
Diane von Furstenburg, Fashion Designer
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CHAPTER SUMMARY

As scientists, economists try to explain the world

using models with appropriate assumptions.
Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
As policy advisers, economists offer advice on how
to improve the world.
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